Implicit cost refers to the opportunity cost of the resources of the business organization also known as notional cost or implied cost where the organization calculates what the business earned if instead of using the resource in the business activity, it used the resource for some other purpose say if the business has rented such asset to another party then how much rent they would have earned will be considered as opportunity cost.
What is Implicit Cost?
As the name implies, implicit costs do not represent real expenses but are considered as a form of opportunity cost for utilization of a company’s assets or resources in general. For instance, if a company sets up a production plant on its own land, by implication it did not earn any possible rent on the same property it could, if it were not to use the resources itself.
It must be borne in mind here that implicit costs do not represent any real expenses, however, the utility of this measure lies in the fact that it helps to evaluate if a particular resource could have been employed better.
Implicit and Explicit Costs
To better understand implicit costs, it would be necessary to understand explicit costs as well, which are out-of-the-pocket expenses, incurred on business activities and operations. By contrast, it helps to take into account probable alternative use of resources and returns thereof. The total costs incurred for a company typically represent the sum total of explicit costs as well as implicit costs.
Use and Relevance of Explicit and Implicit Costs
To understand the relevance of these two types of costs, it is important to know that they are widely employed to calculate different types of profit. There are several ways of defining profit and two of them are accounting profit and economic profit.
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It is calculated by deducting explicit costs from total revenues. This represents the calculation of profit taking into account real expenses incurred on running business operations.
It can only be calculated by deducting both explicit and implicit costs from total revenues which would give a better idea of whether the resources were employed profitably enough or they could have been employed better. Economic profit tends to be lower than accounting profit most of the time.
How to Calculate Implicit Costs?
If renting out a fixed asset could result in higher earnings as compared to what a company earns by utilizing that fixed asset for their operations, it means that the company is losing in terms of economic profit. In simple words, there is no use employing its own building for running its operations, if a company can’t earn more than the implicit cost of renting it out.
The problem with calculating implicit costs is that they are often hard to quantify, do not figure on the financial statements of a company and are generally more or less intangible. Other typical examples of implicit costs would be the time and resources invested in training an employee, depreciation of the equipment etc although depreciation could still be technically considered as an explicit cost by some because it basically represents realistic capital consumption for a resource for which a real expense was made, even if earlier.
ABC invested a sum of $10,000 in a certain business with a view to earning probable profits to the tune of $5000 in a year. However, to make this profit, he had to forego the interest he could earn on the sum. Let us suppose that he had to forego a 12% annual interest, which would have worked out to $1200 in a year. This $1200 represents the implicit cost of investing the sum elsewhere.
Implicit Cost Video
This has been a guide to Implicit Costs, its uses, and relevance. Here we also calculate Implicit Cost along with an example. You may learn more about Corporate Finance with the following articles –